This is China's economic reckoning

The size of its economy grew significantly, and it was very reliant on global growth as well. When the global financial crisis hit, things had to change in China and a new phase emerged at that point in time, when China wanted to keep growing. It felt like it had to keep growing to become a superpower. But how it went about that changed and it shifted to an economy that relied a lot more on debt to stimulate growth. Again, that increased GDP per capita at high rates but at a slowing rate because the quality of growth started to deteriorate.

LW: What challenges does China face today? 

Andrew Swan: We are at that stage now where China's economic model, an investment-led model, which was initially started with the World Trade Organisation and the jobs and the industry that was created around that, has transitioned to one that requires credit to fuel investment. We are now at a point where China actually has very high debt-to-GDP ratios. It's actually higher than in many developed markets, even though it's an emerging market. Relative to other emerging markets, its debt to GDP is actually very high. And, despite continuing to put credit in the economy, the rate of growth has been slowing.

One of the challenges they've faced is because they've been constantly adding investment. When you add investment to an economy, what you're really doing is expanding capacity. Your demand is slowing down because people are getting more indebted. 

These deflationary forces have been building in China now for some time. This is the greatest challenge China now faces. This is what the markets are really worried about - that China can't keep doing what it's done. The quality of growth is deteriorating, you're at a high level of debt, and what you need now is structural reform to find a new growth driver for the economy.

LW: What would that new growth opportunity be? 

Andrew Swan: Well, the opportunity for China is around the economy's very high savings rates. On average, a household saves about 40% of its income, whereas in the West, particularly in places like the US, the savings rate is closer to 10%. The question is, why is the savings rate so high? Because if China can get the savings rate down, you can start to increase consumption. The number one thing China needs to do is to become more of a consumer-driven economy or a service-driven economy. But for the time being, households are very reluctant to do that. So, you need to, I think, improve the social safety network.

People save a lot in China for a rainy day, for healthcare, for education, and even for pensions and retirement. The government needs to come up with a system that better gives people confidence that down the road when they do retire, there is a social safety net there. That will then lead people to spend more today, and that will drive the economy. So, the big opportunity really comes down to what's called "Hukou Reform". That is the social security network in China that hasn't really changed in a long time. But if it does change, you could get a new growth driver for the economy.

LW: What will happen if China doesn’t adapt? 

Andrew Swan: Well, I think you just look at what the equity markets are telling you today. There is fear emerging that without change - if China just continues to do what they've done in the past 10 to 15 years - we're moving into an environment of what's called a "debt deflation trap". That's basically what Japan did in the '90s. It went from a booming economy with rising asset prices to one that went to a slow, multi-decade decline, where prices started to fall and therefore the incentive to consume and invest declines, as set against high levels of debt.

We talk about the "lost decades" of Japan. Well, China is starting to look a bit like that and if they do not do reform - if they don't get a new driver in the economy - the overhang of all that debt and too much capacity in the economy is going to create significant problems. 

I think the reality is China is at that stage of development that most emerging markets actually fail. It's called the "middle-income trap". China's GDP per capita sits in that range, where most emerging markets actually fail. The ones that have succeeded are the ones that have actually found new drivers for the economy, particularly around structural reform. So, this is what needs to happen for China. If they don't, I think you'll find that they're starting to move into a very similar situation to what Japan did in the '90s.

LW: What would be a catalyst to invest in China? 

Andrew Swan: I think structural reform. Again, it's hard to know exactly what that looks like today, but it's something you need to focus on because if they just keep adding stimulus, the markets have worked out it's not the solution, and you'll get bigger problems in the future. So, it's structural reform. Anything that incentivizes the household to increase consumption and reduce savings, I think that is the big opportunity. 

I remember back in the early 2000s when the World Trade Organisation announcement came. At the time, people were trying to work out just how big it was, when it would happen, and trying to quantify it. I think most people missed the point that something structurally had shifted, and this was going to be a multi-year process of China growing and integrating. 

The market multiplied over that period, but I think the initial opportunity was there, you could see the signs that structural reform was coming. I suspect something like that is what we're looking for here. You may not know the immediate impact of it, but the change in direction is what will ultimately set off pretty strong returns for the equity market and the economy.

Man GLG

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